[Colour code: Larry's original article, Bylo's 22Jul02 rebuttal, Larry's 07Aug02 response.]

Response: The point of the article was not to dump on index funds, but to highlight some of their side effects for investors managing their own portfolios.

Last week, Nortel Networks Corp. and other Canadian companies were ejected from the Standard & Poor's 500 index, causing a precipitous drop in their share prices. Once again, the adverse side effects of index funds were brought into view.

Rebuttal: The share price of Nortel has made far greater moves in recent months for several other fundamental reasons, so why is this an issue? And in any case, the S&P committee's elimination of the last remaining foreign stocks from the 500 index is a one-time event.

Response: The ejection of Nortel and other de-indexed stocks are examples of the thousands of stocks added and deleted by index funds every year. This is an issue for investors because of the ongoing impact on their portfolios.

Blame it on Burton Malkiel, author of the 1973 investment classic, "A Random Walk Down Wall Street." He was the first to argue that "efficient markets" require "a no-load... mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages."

Comment: Actually Nobel laureate economist Paul Samuelson and money manager Charles Ellis made that suggestion even earlier.

The first index fund for retail investors was born two years after he wrote his book. By 2001, there were over 200 such funds in North America, representing about 15 per cent of assets under management. Indexation also increased with the advent of exchange traded funds (ETF) in the 1990s.

In addition, in this era of index benchmarking, many managers of actively managed funds now select portfolios similar to an index basket. Such "closet indexing" is a form of job insurance.

Comment: If so many active managers engage in "closet indexing" in order to safeguard their jobs, then what does that say about their opinion of the superiority of indexing?

Response: Perhaps so. The point about closet indexing is that indexing is much bigger than what the number of registered index funds would indicate. Thus, the impact of indexing extends beyond registered index funds.

What a beast Malkiel has inadvertently created. Ironically, the notion of "efficient markets" has led to an increasingly inefficient market – one where stocks are priced less with regard to their fundamentals and more with respect to their presence and weighting within an index.

Price fluctuations caused by index funds reacting to stocks added or deleted from the index are disruption enough.

Rebuttal: While it's true that index changes distort the prices of affected stocks, the effect is only temporary. For large-cap indexes like the S&P 500, the effect is minimal since it occurs at the bottom end of the index. Moreover, total market indexes like the Wilshire 5000 are virtually immune to this issue.

Response: Consider that there is a constant stream of additions and deletions as the hundreds of explicit and implicit index funds update their baskets quarterly and annually, as well as engage in periodical revisions to fix errors such as large caps with low floats. This is a major phenomenon that individual investors need to be aware of when managing their portfolios.

However, the greater distortion would appear to be the less visible one resulting from index funds trying to mirror the market-capitalization weights of stocks in the index basket. When the share price of a company rises relative to others, market capitalization also rises relatively. This in turn increases the company's weighting in the index and leads indexers to buy even more shares to ensure their portfolios track the new weighting.

Rebuttal: Almost all index funds are market capitalization weighted. And they are so for a good reason. When a stock changes in price its weighting in the index changes automatically in lock-step. There is nothing for the index fund manager to do.

Response: During a boom market, money flows into existing index funds and new index funds are created. Much of this new money is directed into the stocks rising the most (because their market-cap weights are rising), thus contributing to momentum investing and overvaluation of index stocks. My objective was to point out another way in which stock investors are affected by index funds.

Thus, a basic problem is that index-fund managers are attracted toward expensive stocks and discouraged from investing in cheap ones. Indexation, in short, provides fertile ground for extreme price movements like the mania that took hold of shares in Nortel and other technology companies.

The stock-market bubble of the 1990s is often attributed to day-trading amateurs. But analysts such as Financial Times of London columnist Barry Riley see it more as a reflection of investment professionals chasing the "relative risk" concept behind indexation.

Comment: If investment professionals chasing the latest hot stock or investing fad were the cause of the market bubble, then Mr MacDonald should should note his own assertion that 85% of the funds they manage are not indexed.

Response: See my points regarding "closet indexing" and "index benchmarking". The phenomenon is much bigger than the number of registered index funds. There is an incentive for active managers to try to mimic the index rather than strike out on his own. If he looses 40% when the index is down 40%, he can blame it on the market; if he loses 40% when the index is flat, he loses his job.

Compounding the overvaluation was the overriding of traditionally limiting factors. For example, companies issuing a lot of new stock have historically been penalized because of equity dilution, but index funds were ready buyers. The issue of new shares increased a company's market capitalization and, in turn, its weight in the index.

Rebuttal: Index funds didn't drive up the share prices of IPOs by multiples on opening day. Greedy active investors did that. Moreover, most indexes, and in particular large cap indexes like the S&P 500 and S&P/TSE 60, don't admit new stocks until years after the initial offering.

Response: Not talking about IPOs. Talking about listed companies issuing additional stock.

Yet another factor was the inclusion in the indexes of companies with small "free floats" – i.e., a low proportion of the outstanding shares were actually available for trading. Indexers pushed these stocks into the stratosphere trying to replicate their market-cap weights in the indexes.

Comment: Again, even in the US, only a small fraction of equity investments are indexed. If there's blame to be laid, then place it at the feet of those who supposedly "know better."

Response: As mentioned above, indexing behaviour also includes closet indexers and the concept of relative risk inherent in index-benchmarking.

Fortunately, the problem with low floats and thinly-traded stocks is being addressed. In Canada, the TSX index is in the midst of a revision that will remove them. But if your portfolio includes one of these candidates, there will be a sudden drop when it is dumped.

In conclusion, index funds spin off a range of pitfalls and opportunities. Of note, value investors should be wary of cheap stocks still in an index. A better bargain awaits once it is dropped.

Comment: Despite the "pitfalls and opportunities" with indexing during the recent stock market mania, index funds somehow managed to outperform the majority of actively-managed funds. That says a lot about the robustness of the indexing concept, warts and all.

Response: Great! All the best to index funds. As mentioned, my concern is not to attack index funds as an investment vehicle. My concern is with individual investors trying to avoid or capitalize on the side effects of index funds.

Larry MacDonald is the author of Nortel Networks: How Innovation and Vision Created a Network Giant and The Bombardier Story: Planes, Trains and Snowmobiles. He can be reached at mccolumn@yahoo.com.

Comment: Bylo Selhi is a Toronto-based fund industry gadfly and proprietor of a website for smart Canadian mutual fund investors. Bylo Rebuts is an occasional series of articles that debunk misguided investment publications.